Agenda item

Funding and Flight Path Update

To update Committee Members on the progress of the Cash and Risk Management Strategy

Decision:

RESOLVED:

(a)  The Committee noted this report on the various elements of the Risk Management Framework, equity protection and currency hedging strategy.

(b)  The Committee were made aware of the risk from potential RPI reform and the balanced action taken to reduce this risk as well as the costs.

 

Minutes:

            Mr Page introduced himself to the Board and presented the flightpath introductory training session.  Further detailed sessions will be scheduled to deliver more detail on the various elements. The presentation covered the main objectives of the flightpath and the following key points were made;

-       The aim of the investment strategy is to deliver a return above inflation, CPI inflation in particular, given that the Fund’s liabilities rise with inflation.

-       Higher returns above inflation means that lower employer contributions are required to make good on the benefits for members. Conversely lower returns above inflation would mean higher contribution requirements for employers.

-       In order to generate return, risk must be taken. However, there is a need to find a balance between taking enough risk to ensure contributions are affordable, but not too much risk that may result in losses on the investments leading to higher contributions in the future.    The overarching objective is to be fair to current and future taxpayers by getting this reasonable balance.

-       The aim of the flightpath strategy is to manage investment risks to improve the affordability and stability of employer contributions.

-       The flightpath is a risk management approach rather than a de-risking mechanism, and works in tandem with the Fund’s well diversified investment strategy.

-       The flightpath seeks to manage (i.e. hedge) risks associated with both the assets and the liabilities. However, it does not manage all investment or liability risks; rather there is an assessment of whether the benefit of managing a particular risk outweighs the cost of doing so. Cost considerations relate to manager and consulting fees, transaction costs, initial and ongoing governance requirements and the overall impact and likelihood of a risk manifesting negatively so the overall objective is not met.

-       The Fund’s biggest risk is rising inflation, given that members’ benefits i.e. the Fund liabilities, are linked to inflation. This is managed through a Liability Driven Investment (LDI) strategy which aims to maximise the certainty of returns above inflation when market opportunities arise thought a yield-based trigger mechanism. The hedge level was previously at 20% for interest rates and 40% for inflation. The Fund has decided to reduce inflation exposure by 20% temporarily in light of RPI reform risk which was discussed in more detail after the training.

-       The flightpath also manages equity downside risk through an equity protection strategy, and the risk that sterling appreciates, reducing the value of overseas assets in GBP terms, through a currency hedging strategy.

-       The flightpath seeks to implement the risk management strategies in an efficient manner. This is evidenced by the collateral “waterfall” approach, which ensures the strategies are supported by enough collateral (essentially a cash like pool of assets backing the hedging framework) but not too much that it acts as a drag on Fund returns. Excess collateral is invested in higher yielding but daily dealing funds in order to generate higher returns but is available for collateral to maintain the hedging position if required at short notice in a low governance manner.

-       The flightpath operates through a series of quarterly Funding and Risk Management Group (FRMG) meetings with advisors and officers, monthly and quarterly reporting, and daily monitoring of funding level and market triggers. This allows for opportunities to be identified and the Committee has delegated powers to the Head of the Clwyd Pension Fund to action those opportunities in a timely manner.

-       As a direct result of implementing the flightpath, the deficit is £250m better off (all other things equal) since its inception in 2014, which equates to c£15m-£20m p.a. in contribution savings for employers. This is clearly a significant positive impact for the Fund and its employers.

 

                      Mrs McWilliam asked how the LDI is managing both liability risks on slide 6. Mr Page confirmed that it looks at both inflation and interest rates, which together provide a yield/return over inflation with a high degree of certainty. This links to the primary objective for the Fund which is to achieve returns above inflation with increasing certainty to provide affordability and stability of employer contributions.  Mr Page clarified it is important that this takes place at the right time as otherwise it would be too expensive to achieve certainty.  This is why there are triggers in place for when the opportunity arises.

            Mrs McWilliam asked whether the Fund should be concerned about being unique in the WPP by having a flightpath strategy. Mr Page confirmed that other LGPS Funds do have similar risk management strategies in place and risk management is an increasing area of focus within the LGPS. Whilst it is not yet on the agenda for WPP to offer a portfolio that can incorporate such a strategy, Brunel have appointed a risk management provider similar to what the Clwyd Pension Fund has in place.

            Mr Middleman noted that not every risk management idea that is considered is implemented. Rather, a risk is assessed and if deemed to be material, a range of options are considered on how it should be managed. Mr Everett welcomed further detail on the range of options in relation to decision making to help provide some further context for the Committee in future.

            Due to the proposed reform by the government to abolish RPI, Mr Page confirmed that the plan was to align what is currently RPI to CPIH in the future, which is similar to CPI but includes housing costs such as changes to council tax rates. From a liability perspective, there will be no impact as the liabilities are CPI linked which is not changing. Mr Page noted that RPI is currently around 1% p.a. higher than CPIH, and the Fund’s inflation hedging assets which are all linked to RPI would fall in value under reforms. Mr Page estimated that the worst-case scenario is that the impact could be a c£100m increase in deficit.

            At the FRMG it was discussed at length whether, due to this potential change, the inflation hedging assets should be restructured. It was concluded that on balance there should be a reduction in the inflation hedge ratio from 40% to 20% as a result to mitigate this risk ahead of the consultation starting on 11 March. The Fund is still exposed to inflation rising and there is also a risk that the reform does not proceed, which is the reasoning behind only reducing half the exposure and not all. Therefore, the £100m increase in deficit stated above would now be £50m in the worst-case scenarios modelled. Mr Page confirmed that longer term, the Fund should seek to return back to the 40% inflation hedge ratio once the outcome of the consultation was clearer. The consultation will run from 11 March 2020 for 6 weeks and the Chancellor has committed to a response on this by July 2020.

            The Chairman asked whether there is any allowance for housing costs in CPI. Mr Page confirmed that it is not included in CPI but is included in CPIH. CPIH is the UK’s national statistic for inflation even though it is not well used or known.

            The Chairman queried whether the consultation on government tax relief is due to come in. Mr Middleman said that he would be surprised if it did at this Budget but there could be a consultation announced on the issue given the sources of finance needed by the Government.   The Committee will be updated in due course on any issues arising.

            Mr Page added that at 31 December 2019, the approximate funding level was 94%, the equity protection had made a £38m gain since inception, and the currency hedging had made a gain of £9m since inception.

The report was noted and no further questions were asked.

RESOLVED:

(a)  The Committee noted this report on the various elements of the Risk Management Framework, equity protection and currency hedging strategy.

(b)  The Committee were made aware of the risk from potential RPI reform and the balanced action taken to reduce this risk as well as the costs.

 

Supporting documents: